International Economic Conditions

Overall, the data available over the past month had indicated a continued consolidation
in the global economy. Data for June quarter GDP were now available for most
economies and showed that growth in the Asian region had been much stronger
than elsewhere. However, there had been some upside surprises in other countries,
including positive growth in France and Germany in the quarter. Industrial
production in a number of countries had been boosted by incentives for the
purchase of cars and other durable goods. There was therefore a question about
the sustainability of the recovery, in particular whether the growth that had
been seen was largely a one-off effect of stimulus measures or if there was
also a fundamental improvement.

Members discussed the divergence that was being seen in different parts of the global
economy. In recent years, there had been much discussion about the desirability
of stronger demand growth in Asian economies and this was now occurring. To
the extent that Asia continued to grow more strongly than elsewhere, this would
be positive for the Australian economy, with Australia's largest export
destinations now in Asia.

Members were briefed on the recent data for the Chinese economy, which had been somewhat
mixed. Car sales had risen very sharply and export volumes had also been growing,
including recently to the United States and Europe. However, growth in industrial
production, fixed asset investment and credit was estimated to have slowed.
Members also discussed trends in the Chinese steel industry, including what
evidence was available on the build-up of inventories of iron ore and steel.
Overall, members observed that some slowing in the Chinese economy relative
to the rapid pace in the June quarter had been inevitable but that the longer-term
prospects were strong.

Developments elsewhere in Asia indicated that growth was continuing to recover. India
had recorded two quarters of solid growth in the first half of 2009, boosted
by an easing of both fiscal and monetary policy. In South Korea, industrial
production had grown by nearly 30 per cent since the start of the year
and was now back to its previous peak. There had been a particularly strong
recovery in production of electronic components, some of which were exported
to China for assembly. The Japanese economy was also doing better than earlier
expected, though part of the growth in the June quarter was accounted for by
measures to boost sales of cars and household appliances. Nevertheless, there
was a significant amount of spare capacity, with Japanese output 7½ per
cent below its peak and the unemployment rate, at 5.7 per cent in July, at
the highest level in the five decades for which there were comparable data.

The data for the United States indicated that the pace of deterioration in the labour
market was easing. However, household spending had shown essentially no growth
so far this year, and the household saving rate had risen. The US economy was
expected to grow in the September quarter, after contracting by 4 per
cent over the previous year.

Members were briefed on global trends in credit growth and housing markets. Developments
in business credit had been fairly similar across countries, with falls in
2009 in a number of advanced economies as companies reduced debt levels in
an environment of tighter credit standards by lenders. In relation to housing
markets, members observed that in countries that had experienced better economic
outcomes and/or fewer financial sector problems (e.g. China, Canada, Norway
and Australia), house prices now appeared to be rising quite solidly and were
above or around earlier peaks. Even in the US and UK, which had earlier experienced
significant falls in house prices, there had been some up-ticks recently.

Domestic Economic Conditions

The flow of information on the Australian economy over the past month had been mostly
positive. The staff's expectation was that GDP data for the June quarter,
due to be released the day after the meeting, would show a moderate increase
in output, with growth in household consumption, business investment, public
spending and exports.

Measures of sentiment had continued to strengthen. Consumer sentiment had risen sharply
over the three months to August. Liaison with retailers suggested that household
spending had softened somewhat in July but had been better in August.

Measures of business confidence and business sentiment had also risen to be modestly
above average. The data for business investment in the June quarter indicated
a strong rise in spending on plant and equipment, with a sharp increase in
spending on a wide range of capital goods, including cars. However, this mostly
reflected the bringing forward of spending to qualify for tax allowances. Car
sales had subsequently fallen in July. Building construction had fallen sharply
in the June quarter, but engineering construction had risen strongly.

Members discussed the broader outlook for investment, which – as a share of
GDP – was around the highest levels in the 50-year history of the national
accounts. The capital expenditure survey pointed to some near-term weakness
in private investment, though less than expected earlier in the year. Developments
in the resources sector, especially for LNG, pointed to significant strength
in the medium term. Public investment would increase because of the fiscal
stimulus packages and state government infrastructure plans. Members also discussed
the trend in dwelling investment. They noted that even though the number of
new dwellings completed had been lower in recent years, dwelling investment
as a share of GDP had held up, due to the trend towards larger and higher-quality
homes and an increase in the share of alterations and additions.

Business credit data showed a further fall in July, but there were some tentative
signs of a slowing in the rate of decline. Equity raisings had remained strong.
The most recent profits data showed a pick-up in the non-mining sector in the
June quarter, but mining profits had declined following earlier falls in commodity
prices.

The data for June quarter export volumes showed most categories were growing or holding
up reasonably well. Manufacturing exports were the exception, and had fallen
broadly in line with the falls seen in many other countries. On average, commodity
prices had been broadly steady since the last meeting. Iron ore spot prices
had weakened over the previous couple of weeks, although they remained above
the contract prices agreed with Japanese and Korean steel mills.

The most recent monthly labour market data continued to suggest that the deterioration
in the numbers employed and in unemployment had been less than feared earlier
in the year. There had been a noticeable increase in flexibility in hours worked.
Members noted that this had been beneficial for firms, employees and the broader
economy.

The wage price index showed a significant moderation in private-sector wage growth
over the first half of the year, although public-sector wage growth had not
slowed much. The slowing in private-sector wage growth was consistent with
reports that some companies had implemented wage freezes, and members judged
that it would be helpful in minimising job losses and in exerting some downward
pressure on underlying inflation from the current elevated levels.

Financial Markets

Sentiment in financial markets had generally consolidated further over the previous
month.

Spreads in money markets had narrowed further, gradually returning towards more normal
levels. There had been no significant changes in monetary policy in the major
economies, although the Bank of England had expanded its asset purchase program.

Issuance in global bond markets had been subdued in August, mostly reflecting the
northern summer holidays, and there had been a very significant drop-off in
issuance of government‑guaranteed debt. Members noted that recent guaranteed
issuance in the Australian market had mostly been by branches and subsidiaries
of foreign banks. The major banks had raised some longer-term offshore unguaranteed
debt at a yield that was only slightly above the all-in cost of a guaranteed
issue.

There were some favourable signs in the Australian residential mortgage-backed securities
market. The gap between secondary market yields and primary market yields was
continuing to close, such that the prospect of issuance without the support
of the Australian Office of Financial Management was increasing.

Equity markets had mostly strengthened over the past month, with China a notable
exception. Chinese equities had fallen significantly from their recent peak,
with concerns over the rapid credit expansion and its possible curtailment
contributing to significant volatility, which had spilt over to other markets
on occasion.

The Australian equity market had risen, especially financial sector stocks. Although
underlying profits of Australian companies had fallen significantly, recent
earnings reports had mostly met or exceeded analyst expectations. Issuance
of new equity had been running very strongly in the quarter to date.

Turning to banks' funding, members noted that there had been a continuation
of the strong competition for deposits. Together with an increase in term interest
rates, which were rising because of expectations of monetary tightening, this
was contributing to an increase in bank funding costs. Banks had raised interest
rates on their fixed-rate lending and members noted there was market speculation
that variable mortgage rates might also be increased. Average business lending
rates had risen slightly, as banks continued to adjust customer risk margins
upwards as loan facilities were renewed.

Financial System

Members were briefed on the Bank's half-yearly assessment of the financial
system. The discussion focused on the improvement in conditions in the global
financial sector over the past six months; the resilience of the Australian
financial system; improvements in sentiment among Australian households and
businesses; and developments in regulation of the financial sector.

Members noted that the extreme risk aversion prevailing in global markets in the
wake of the Lehman Brothers collapse last year had dissipated. Investors had
become more confident, which was evident in a bounce-back in global equity
prices. The recovery in share prices had been proportionately larger for banks
than the broader equity market. There had been similarities in the performance
of the Australian equity market.

Members observed that financial conditions in some key countries remained challenging,
as macroeconomic conditions continued to weigh on loan quality. Commercial
property seemed to be a key point of weakness in several countries.

Members noted that the Australian financial system had continued to perform relatively
strongly. Although loan impairments were rising, mainly relating to business
lending, the large Australian banks had reported solid profits for the latest
half-year, as they had throughout the period of the financial crisis. The banks
remained well capitalised, and had strengthened their positions further with
additional raisings during the past year. With investor risk appetite returning,
banks had been increasingly willing to tap markets on their own credit standing
and without the support of the government guarantee in the past couple of months.

Members discussed overall lending standards, which had clearly tightened since the
start of the crisis. They noted that while larger companies had been reducing
debt and banks had reduced exposures, credit remained available to high-quality
borrowers, albeit at higher spreads. Although commercial property was currently
the largest component of non-performing assets, the construction cycle had
not been as pronounced as in the late 1980s. This suggested that there was
a smaller amount of overbuilding in the market, including in Perth and Brisbane,
where the largest falls in commercial capital values had been seen to date.

In the non-financial sector, members noted that sentiment among Australian households
and businesses had improved significantly. Many firms were still trying to
strengthen their balance sheets by reducing debt and raising equity. For households,
net worth had fallen during the past year but the latest figures showed it
was now recovering, reflecting higher prices for both shares and houses. Members
observed that household interest payments as a share of disposable income had
fallen substantially and that household borrowing was growing at a moderate
rate.

On regulatory developments, members noted the ongoing debate in various international
fora. Details on possible changes to regulations covering bank capital and
other standards were still being worked out, but were likely to result in higher
capital and liquidity requirements around the world.

Considerations for Monetary Policy

The information presented to members showed that the situation in the global economy
was continuing to improve. Of most significance to Australia, the Asian region
had recorded strong growth in the June quarter. While this had been largely
driven by domestic demand in these economies, reflecting strong economic stimulus,
there were also recent signs of a pick-up in their exports. Outside Asia, most
economies had experienced another fall in GDP in the June quarter, though more
recent information suggested that the majority of these economies were now
approaching a turning point.

An important question for members was whether the global economic improvement would
be sustained, or whether it was mainly a reflection of the strong macroeconomic
stimulus that had been applied over the past year and might in due course fade.
Members were also conscious that, even though financial market conditions had
improved significantly and debt markets were beginning to function again, banks,
corporates and households in many countries still faced significant balance
sheet adjustments. This too could serve to limit growth.

Members concluded on balance that the global economy was most likely on a sustained,
if modest, recovery path, though it was still too soon to be confident of this
assessment.

Members noted that indicators of the domestic economy over the past month had again
been better than expected. GDP figures due to be published the next day would
most likely show that a moderate rise in output had occurred in the June quarter,
which meant that the slowdown in GDP had been significantly less than forecast
earlier in the year. Consumption, investment and exports had all shown unexpected
resilience. Measures of confidence of both households and businesses had recovered
strongly.

Members noted that it was hard to disentangle the contribution that Asian demand,
fiscal stimulus and easier monetary policy had each made to the better-than-expected
outcomes. There were signs that some of the unexpected strength in investment
in the June quarter owed to the pull-forward of spending to qualify for tax
concessions that ended in June, but investment plans for the year ahead had
also been revised up. Information from liaison suggested that household spending
might be holding up reasonably well even several months after the government
payments had ended. There were some signs that Chinese demand for resources
had not continued at the exceptional pace of the June quarter, but liaison
with resources companies suggested that they were very confident about medium-term
prospects.

Members also noted that business credit was still very weak and that borrowers were
facing tight credit conditions and rising borrowing costs as banks continued
to review risk margins as lending facilities were renewed. For some sectors,
particularly those related to property, this was likely to continue to be a
brake on economic activity in the near term. The rise in market yields, in
expectation of a monetary tightening, was also adding to borrowing costs.

Members were reassured by the clear signs of wage moderation in the economy, as this
would help to contain inflation in the near term. Nonetheless, with underlying
inflation still relatively high on the latest reading and economic activity
substantially stronger than expected, members were conscious of the need to
balance the task of controlling inflation over the medium term with that of
supporting economic recovery.

At the previous meeting, members had agreed that if the economy continued to evolve
as in the latest forecasts, the Bank would in due course need to adopt a less
expansionary policy stance. The information at this meeting suggested that
economic conditions were indeed evolving broadly in that way. Nonetheless,
some uncertainty remained about the outlook both abroad and at home.

As at the previous meeting, members noted that the policy decision in the near term
involved balancing the risk of over‑staying an accommodative stance,
and that of prematurely tightening and adversely affecting confidence and demand.

The meeting concluded that the balance was best struck by leaving the cash rate unchanged
for the time being, pending further evaluation of incoming information at future
meetings.